This article is an excerpt from The Art of Tendering: A Global Due Diligence Guide, which is available for purchase.
In its June 2018 report entitled DOD Should Comprehensively Assess How Its Policies Affect the Defense Industry, the U.S. Government Accountability Office (GAO) concluded that the Department of Defense (DOD) should review how it makes interim payments in major projects. The report considered the distinction between progress payments, which are made based on costs incurred by the contractor, and performance-based payments, which are made once the contractor meets defined contract milestones:
DOD has long recognized that the contracts for items like weapon systems are capital intensive in nature and take a long time to produce. Contract financing assists the defense contractor in managing expenses, such as material, labor, and overhead. In such cases, DOD can agree to help finance these expenses as the work progresses through various types of contract financing payments, including progress payments and performance-based payments.
-
Progress payments based on cost are determined as a percentage of the costs incurred by the contractor as work progresses. Currently, DOD pays 80 percent of incurred costs of large business concerns receive progress payments on the basis of cost, contractors are required to have an accounting system and controls that are adequate for proper administration of progress payments. The cognizant contract administration office is to maintain surveillance of the contractor’s accounting system as appropriate, and the Defense Contract Audit Agency is to audit the accounting system. DOD provides contract financing on fixed-price type contracts for non-commercial items.
-
Performance-based payments enable the contractor to be paid for achieving certain contractual milestones, such as delivery of a major subcontracted component. DOD can pay up to 90 percent of either the contract’s price or the price of a deliverable item using performance-based payments. DOD’s performance-based payments guide states that these payments should not be structured such that they amount to advance payments, which in general terms are payments made before work is complete on a contract regardless of what performance milestones are met. Unlike progress payments, however, performance-based payments do not require that the contractor have an adequate accounting system.
As the report noted, notwithstanding prior legislative reforms aimed at moving towards performance-based payment methods, an increasing number of DOD contracts were using progress payments as their method of payment:
Congress enacted the Federal Acquisition Streamlining Act (FASA) in 1994 to provide the executive branch with requirements to improve the process for acquiring goods and services. FASA, among other things, established performance-based payments “wherever practicable” as a form of contract financing. In 1995, the FAR Council amended the FAR to enable the use of performance-based payments up to a maximum amount of 90 percent of the contract’s price. In 2000, DOD issued a rule amending the DFARS to emphasize that performance-based payments were the preferred method of financing. The rule required contracting officers to consider and deem performance-based payments impracticable before deciding to provide progress payments. This rule was part of a larger effort by DOD to make contract financing procedures easier to understand and to simplify related provisions. DOD subsequently issued a user’s guide in 2001 to help its contracting personnel and contractors in using performance-based payments.
Despite the provisions to encourage the use of performance-based payments when appropriate, DOD subsequently initiated department-specific actions that, according to industry officials, decreased the frequency with which they received performance-based payments on defense contracts.
The GAO also observed that the DOD had not conducted a comprehensive assessment of the impact of its payment methods on contractors since 1985. It recommended that a study be conducted, given changing market conditions and the overall lowering of interest rates. As the report concluded, the study is necessary to ensure that the government is not bearing an unnecessary level of risk in using progress payments rather than milestone payments, and to ensure that the government is not giving unfair advantages to existing contractors over new entrants through its contract financing policies:
DOD and industry officials have acknowledged that the defense industry, economic and market conditions, legislative and regulatory requirements, and business practices have all changed since the issuance of the DFAIR study in 1985. Despite this recognition, DOD has not conducted a comprehensive assessment of how its contract financing policies affect the defense industry in more than 30 years. Without assessing the collective impact of these changes, DOD may be assuming too much financial risk or providing contractors with levels of working capital that are not commensurate with what is needed to help finance long-term projects, and affecting its ability to attract new entrants into the defense market. That assessment, however, should not be a one-time effort. A prior DOD study, our work, and the department have acknowledged the need to do so on a regular and recurring basis. Without a comprehensive and systemic assessment, conducted on a recurring basis, of DOD’s contract financing policy’s effect on the defense industry, DOD will not be in a position to understand whether current or future policies are achieving their intended objectives.
As this report illustrates, the use of progress payments should not be assumed to be the appropriate method of payment for major projects. Government institutions should consider the use of milestone payments as the preferred installment payment option since milestone payments better protect the entity from the cost overrun risks associated with contract failures and project delays.
